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EMIR collateral damage

Last month the EBA, ESMA and EIOPA (together, the ESAs) published their long-awaited revised draft of the regulatory technical standards on the requirement to collect and post margin in respect of uncleared OTC derivative contracts (theCollateral RTSs). These new rules go far beyond current market practice on margining and will be relevant to anyone entering into OTC derivative contracts where there is an EU connection.

This followed the publication in March this year by the International Organization of Securities Commissions (IOSCO) and the Basel Committee on Banking Supervision (BCBS) of an amended set of internationally agreed principles covering margin requirements for uncleared OTC derivatives (the BCBS/IOSCO Paper). The final consultation period on the Collateral RTSs is now closed and they are expected to be finalised in early Autumn.

The Collateral RTSs set out the rules which will implement the final, and arguably most costly, provisions of EMIR. Every OTC derivative entered into between persons that fall within the clearing obligation under EMIR will be subject to these new requirements, unless it is cleared. This will radically change the economics of the EU OTC derivatives market and will require widespread re-papering and renegotiation of OTC derivatives relationships.

The implementation timeline for the Collateral RTSs follows the BCBS/IOSCO Paper. Phased implementation is now due to start on 1 September 2016 for the very biggest players in the market, with full implementation for all in-scope entities by 1 September 2020.

By the time they are fully implemented, these requirements will apply to a much wider range of trades than they will at the outset. The scope of what is an OTC derivative contract is due to expand further in the physical commodities space with the implementation of MiFID II in January 2017.

Overview The Collateral RTSs represent a more fully fleshed-out set of draft regulatory technical standards than those put forward in April 2014. We now have more detail on applicable margin models, haircuts, eligible collateral and the conditions for reliance on the intra-group exemption.

The Collateral RTSs do away with some of the more controversial elements of the earlier proposals, including:

that an FC1 or NFC+2 would be required to collect margin from all third country entities (even if they were of a type that would be classified as NFC-3 if they were established in the EU); and

the requirement for a legal opinion on segregation of initial margin, although there is still a requirement for an annual independent legal review (which may still amount to a legal opinion, in practice).

They introduce a degree of phase-in for variation margin (VM) as well as initial margin (IM) requirements. Under the previous proposals, there was no phase-in for VM. The phase-in for IM and VM is different, which means that in many cases VM requirements will apply first, with IM coming later. They also extend the benefit of the €50 million threshold before margins need to be collected to NFC+4 .

Variation margin is collateral calculated, broadly, to reflect the net exposure of an in-the-money party to the out-of-the-money party. Variation margin is routinely calculated on a daily basis and payments, reflecting the size of that net exposure, are often made daily. As exposure levels vary with market fluctuations, so the variation margin position will change.

Initial margin is designed to provide a buffer above that set by the level of variation margin. In a close-out, the market may have moved since the previous variation margin calculation and the market may move again before the collateral is realised. Initial margin is collateral designed to provide a sufficient buffer to address that risk.

All that said, several issues remain.

One such issue is that there is no indication of any transitional provisions for EU entities which deal intra-group with non-EU entities to give time for the Commission to make equivalence rulings under Article 13 of EMIR. A positive equivalence ruling for the jurisdiction where the non-EU entity is established is one of the conditions to being able to qualify to use the intra-group exemption under EMIR. The ESAs are unlikely to suggest transitional relief themselves, as they regard this as a matter for the Commission. The Commission has put forward a three-year transitional provision for the intra-group exemption to the clearing obligation for interest rate swaps, but it has not yet stated that it would do the same for the collateralisation requirement. This could make for uncertain times ahead for multinationals with a centralised treasury or risk management function which operates across EU borders.

A timeline showing the IM and VM phase-in and a summary of some other key provisions of the Collateral RTSs is set out below.

IM must be segregated from proprietary assets so that it will be protected from the insolvency of the collecting party. This will drive increased collateral management accounts provided by custodian banks.

Phase-in of IM: This is based on threshold tests. Entities over the threshold are subject to the requirement to exchange IM where they trade with other entities that are also over the threshold. Calculations against the IM thresholds in the phase-in period are measured using the aggregate average gross notional amount of all non-centrally cleared OTC derivative contracts of all entities in the group recorded on the last business day of March, April and May of the then current year. The IM threshold-based phase-in timeline is set out in the table above.

Disapplication: IM need not be collected for all new contracts from January of each calendar year, where one of the counterparties is below the €8 billion threshold (averaged across June, July and August of the preceding year).

Recalculation: IM must be recalculated and called at least every 10 business days and within one business day of the occurrence of certain events, as set out in the Collateral RTSs.

Calculation method: IM can either be calculated under the standardised approach set out in the Collateral RTSs (the standardised method) or according to an approved model. The Collateral RTSs set out conditions for these models and a requirement that they be recalibrated at least annually.

The standardised method applies a set ‘risk factor’ percentage to different types of derivatives to arrive at a gross IM figure per netting set of transactions. It applies a set formula (taking into account the replacement costs of the in-the-money trades in a netting set) to work out what the IM requirement should be for those trades.

Group IM threshold: Under the new proposals, both an FC and an NFC+ may provide that IM is not collected where the total IM required to be collected from a counterparty calculated at group level is equal to or lower than €50 million. There are conditions attached to this, including requirements to set out in risk management procedures how to allocate received IM among relevant group entities, monitoring of thresholds at a group level and records of exposures to each single counterparty within a group.

Variation Margin

Frequency of calculation and collection: It must be calculated at least on a daily basis and collected within three business days of the calculation date (one business day where no IM is required).

Collateral and haircuts: VM is to be collected in cash or, subject to prescribed haircuts set out in the Collateral RTSs, non-cash/assets.

Other key points

Covered entities: The requirement to collect and post margin applies to an FC and an NFC+ when it is trading with another FC or NFC+. It also applies to them where they deal with third country entities which would be classified as FC or NFC+ were they established in the EU (TC+). In other limited circumstances, it can apply to two TC+ entities where they trade with each other.

Trading with NFC-/TC-: Risk management procedures may include the provision not to apply the margin requirements when dealing with an NFC- or a non-financial TC that would be considered as NFC- were it established in the EU (TC-). There is now no requirement for a written agreement to disapply the rules with an NFC- and this exemption has been extended to those trading with a TC-.

Intra-group exemption: The procedure by which national competent authorities will consider notifications and applications to use intra-group exemptions (and how long they have to consider them) is set out. The Collateral RTSs also clarify which risk management procedures must be met and what would amount to “legal and practical impediments” on transferability of own funds and repayment of liabilities.

‘Practical’ impediments include:
- where sufficient assets are not or may not be freely available to satisfy transfers or repayments when due
- where there are operational obstacles to transfers or repayments.

Eligible collateral: This must be of a type that can be liquidated in a timely manner by the holder (and be of a type for which the holder has market access) on default of the posting counterparty. It must also fall within one of the asset classes set out in the Collateral RTSs. These include:

cash

high-quality securities (including high-quality government, corporate and covered bonds, the most senior tranche of some securitisations, but not re-securitisations)

equities included in a main index

gold (in the form of allocated bullion of recognised good delivery)

certain shares or units in UCITS that meet eligibility criteria.

Letters of credit and guarantees do not qualify.

No frontloading: Margin requirements will apply only to transactions entered into (or novated) after the relevant phase-in date to avoid retrospective effect.

Independent legal review: At least annually, a firm must perform an independent legal review to verify the enforceability of its netting arrangements and whether the segregation arrangements for IM meet the requirements in the Collateral RTSs in all relevant jurisdictions. This has been watered down from the previous proposal to require a legal opinion, although in practice it may amount to much the same thing.

FX products: Parties can agree not to apply IM to the physically-settled portion of FX forwards, FX swaps or on the principal amount under a currency swap (but VM would still apply).

Minimum transfer amount: Parties can agree that an exchange of collateral is only necessary if the change in IM and VM requirements on recalculation is over a minimum threshold amount, which can be set at up to a maximum of €500,000. Once exposure increases beyond this amount, the full amount (including the minimum transfer amount) must be transferred. Parties can agree separate IM and VM minimum transfer amounts, but they should not exceed €500,000 together.

Covered bonds: Covered bond issuers or covered pools have a conditional exemption from the requirement to post margin for swaps linked to covered bonds entered into purely for hedging purposes.

Currency differential haircuts for cash collateral: Where IM is posted in cash, there is no haircut if the IM cash collateral is posted in the termination currency specified in the contract. Where VM is exchanged in cash, there is no haircut if it is in the same currency as the transfer currency specified in the contract. If there is a currency differential or no termination or transfer currency is specified, a haircut must be applied to cash collateral.

Diversification: The Collateral RTSs include criteria to ensure collateral held in sovereign bonds (and equivalent securities), non-sovereign bonds and securities issues by credit institutions and investment firms are diversified. Concentration limits on sovereign debt securities will apply only to the largest institutions or those for which the total initial margin to be collected by it exceeds €1 billion (across the group).

Rehypothecation/ Right of re-use: The Collateral RTSs prohibit the re-hypothecation, re-pledge or re-use of collateral posted as IM. There is a limited exception for IM “posted in cash [which] can be re-invested by the collecting counterparty or the custodian only for the purpose of protecting the collateral poster, and subject to an agreement between the counterparties”.

Disputes: In case of a disputed margin call (IM or VM), the undisputed amount should be collected.

Documentation: Parties must have written trading documentation comprising all material terms governing the trading relationship with their counterparties, including payment obligations, payment netting, events of default and termination events, calculation methods, close-out netting arrangements and which governing law applies.

Next Steps

The ESAs are expected to finalise the Collateral RTSs in early Autumn. It is expected that standard industry documentation will need to be amended in the coming months to reflect the new rules.

Further information: The Collateral RTSs and the BCBS/IOSCO Paper are available at the links below:

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